China: A Bull Market for Credit Default Swaps

by Ivan Martchev | July 5, 2013 7:00 am

The recent cash crunch in China’s banking system is a contributor to a massive move in the country’s five-year sovereign credit default swap, from 66.93 basis points at the beginning of the year to 143.02 bps at the end of Q2.

However, it’s just a symptom — not a cause — of a larger economic slowdown in China.

In Wall Street: Money Never Sleeps, Jacob Moore tells Gordon Gekko: “Credit default swap is a good idea. It’s the execution that isn’t.” I happen to think there is nothing wrong with the execution of CDS — or how people trade them over-the-counter — but with the lack of understanding of how CDS’ work, particularly regarding the type bonds they reference.

With the risk of oversimplifying, a credit default swap is like a leveraged put option on a bond, be it sovereign — as is the case with China here — or any other kind. If the credit risk is high, the price of CDS is high, and vice versa. Like insurance, an institutional investor gets to pay every year over five years for protection against a credit event, and when the contract runs out, that institutional investor can renew it again at the new market rate.

Unlike insurance, an institutional investor can speculate in the over-the-counter credit default swap market by buying or selling such naked CDSs without owning any bonds and without waiting five years. (There is no real closing out of a CDS trade that is meant to last five years. If a trader wants to close a long CDS position immediately, he can sell some CDS protection on the same bonds. The two positions cancel each other out, even though they remain on the books.)

Unlike options, one can only buy or sell swaps — there are no “puts” and “calls” here. Also unlike options, this is only an institutional market, where parties need an ISDA license[1] to operate, though there is one case of a feisty individual[2] being approved for a license.

Why should investors care that Chinese CDSs had such a move, even though they still are at half the levels of the swaps of developed markets like Italy or Spain?

The U.S. credit markets first showed a massive economic problem brewing under the surface as early as February 2007. If an investor didn’t know how collapsing mortgage structures were resulting in skyrocketing CDS prices back then, an investor would think everything was “fine.” An investor unaware of the monstrous move in CDS’ in early 2007 would not know that later, such credit market developments would result in record banking system losses that nearly took down the whole system.

The Chinese CDS move in 2013 is a record 113.68% — the largest such relative move of any sovereign issuer — although a consultation with a bond expert[3] confirmed that one should not be looking only at percentages, but at the total number increase of basis points.

So in this case, Chinese CDS rose 76.09 bps in 2013, while other major BRIC countries registered similarly impressive moves. Brazil’s CDS rose a larger 88.77 bps in 2013 to end the first half at a higher (more risky) 200.20 bps, while Russia rose by an even larger 91.55 to end the first half at an even higher than Brazil rate of (riskier) 224.25 bps. India does not have sovereign CDS due to the low level of U.S.-denominated debt, but the State Bank of India (used as a proxy) has CDSs that are about double those of Russia and Brazil, indicating it is the riskiest BRIC country. For comparison, U.S. CDS dropped over the six-month period by 10.34 bps to end at 30.34 bps, indicating that U.S. credit risk fell.

The credit risk in China is increasing amid a crackdown on lending done by unregulated subsidiaries of smaller banks or standalone finance companies with no official oversight. Such unregulated lending is popular, as an estimated 97% of the nation’s 42 million small businesses don’t have access to normal bank loans. Also, consumers can get wealth management products that bundle such unregulated loans that yield as much as 7%, while “normal” deposit accounts in China carry an interest rate of about 3%, so retail funds flow to such finance companies.

The problem has gotten so large that the need to rein in this lending might result in overzealous regulators willing to see some of those finance companies going bust. The PBOC did not immediately step in during the recent banking system credit crunch in June, and a further crackdown on such lending is likely to put further pressure on the Chinese economy as less credit is available. This is even more relevant because Chinese GDP was already notably[4] slowing before this latest crackdown intensified.

There is a feedback loop where more regulatory crackdown results in more bad loans for Chinese banks and unregulated finance companies, which have been rising for six straight quarters. This has put pressure on Chinese bank stocks, causing them to trade near record-low valuations. Most Chinese banks do not have ADRs, save for a large Chinese financial in the face of a life-insurer — China Life Insurance (LFC[5]), whose shares now trade below[6] the infamous March 2009 low in global stock markets. Compressing valuations are evident here; LFC shares traded at 2.9 times book in March 2009, but at present[7] they trade at 1.8.

A slowdown in China affects other BRIC markets disproportionally thanks to the economy’s sheer size and the effects on trade and many commodity markets, where China often is the No. 1 or 2 global consumer. The estimated Chinese 2013 GDP will be $9.02 trillion, while Brazil, Russia and India are at $2.45 trillion, $2.21 trillion and $1.97 trillion, respectively — combined, they’re still smaller than the Chinese economy! When China sneezes, Brazil and Russia catch pneumonia, particularly because those two countries are more exposed to commodity demand. India is the most domestic demand-driven BRIC economy.

A confluence of developments, among which the Chinese economic slowdown is a major influence, has caused a selloff in BRIC equity markets. Brazil (-22%), Russia (-16%) and China (-13%) are the worst major stock markets in 2013 according to their large-cap benchmarks. India was flat, but the local large-cap benchmark had been lagging a while. I dug a little deeper to see what is going on with the small-cap sectors in those countries — they tend to show the real economy of emerging markets better — and I discovered a somewhat different but more troubling picture.

Chinese small caps included in the iShares MSCI China Small-Cap ETF (ECNS[8]) are primarily H and B shares. They are flat and do not reflect the stress in Chinese large caps, which have felt the quick liquidations of big investors. The situation in Russian small caps as represented by the Market Vectors Russia Small CapETF (RSXJ[9]) is on par with large caps as the Russian market has been affected by the recession in Europe as the EU is its largest trading partner[10]. The situation in Brazilian and Indian small caps — as represented by Market Vectors Brazil Small Caps ETF (BRF[11]) and the Market Vectors India Small Caps ETF (SCIF[12]) — can only be characterized as dismal[13], compared with the large-cap sectors in those countries.

While going through a lot of economic and market indicators, I did not get the sense that the situation in China is close to being resolved. It seems that the new political leadership there will implement its financial system crack down, and in a best-case scenario, will (hopefully) succeed without causing a recession.

The elephant in the China store is not done moving.

Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates holds positions in China Life Insurance Co. for some of its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.